Escaping the Subsidy Trap
EMBARGO: 00.01hrs, 22 Sept 2004 Authors Contents Paul Ingram Paul Ingram is Senior Analyst at the British American Security Information Council (BASIC), and has been a Consultant working for Oxford Research Group (ORG) on arms export subsidies since 1998. He was co-author with Ian Davis of The Subsidy Trap: British Government Financial Support for Arms Exports and the Executive summary 3 Defence Industry, published by Oxford Research Group and Saferworld in July 2001. With Mark Ingram he has provided written and oral evidence to the Trade 1: Introduction 5 and Industry Committee on ECGD subsidies earlier this year, as well as advice to a number of government officials in the area. 2: Myths behind UK Government support Roy Isbister for arms exports 8 Roy Isbister is the Head of the Export Controls Team at Saferworld. He completed his Masters in International Relations from the London Centre of International The jobs myth 8 Relations of the University of Kent in 1998. He then worked as a member of the arms export controls team at Saferworld, before spending a year looking at The balance of trade myth 13 humanitarian intervention issues for the International Security Information Service (UK). He returned to Saferworld at the beginning of 2001, as Project Manager, The cheaper defence procurement myth 15 Arms Export Controls. In the last four years he has worked and written extensively on arms export issues, in particular with regard to the UK and the EU. 3: Case study: Hawks to India – A £1bn subsidy? 18 Acknowledgements 4: The Subsidies 22 The Authors would like to thank their support teams and senior staff for additional research, editing and proof reading, especially: Vanessa Haines, Stephen Direct assistance: £31m subsidy 23 Pullinger, James Kemp, Mark Ingram, Joseph Miller, Ian Davis and John Slaboda. We would like to thank our printers, who show extraordinary flexibility with a swift Export credits: £222m subsidy 27 turn around. Responsibility for the reports contents rests entirely with the authors.
Distortion of MoD procurement: £200m subsidy 29 Financial Support Development of new systems (R&D): This publication was made possible by the generous support of: Joseph Rowntree up to £483m subsidy 30 Charitable Trust; the Marmott Trust; the Polden Puckham Charitable Foundation; the Ploughshares Fund; and the Oakdale Trust. Unquantifiable elements 33 Price: £5 ISBN: 1-904833-05-5
5: Conclusion and policy recommendations 35 Printed on 100% post-consumer recycled paper using soy-based inks and 100% green energy by Oxford Greenprint, 125 Magdalen Road, Oxford OX4 1RQ; tel: 0845 3451398, email: [email protected].
Appendix: Background to ECGD calculations 38 All three authoring organisations are charities registered in the UK: BASIC: 1001081; Saferworld: 1043843; Oxford Research Group: 299436
1 2 Summary Escaping the Subsidy Trap
UK Government support for defence exports is made up of direct Executive Summary subsidies, export credits, distortion of Ministry of Defence (MoD) procurement and a proportion of government spend on development There are few if any economic or employment benefits from the costs. Explicit financial (and political) support of £31m per year is provided considerable government support to arms exports. This report, published through such organisations as the Defence Export Services Organisation by three leading UK security policy think tanks, explodes the myth that (DESO) within MoD. Export credits are provided as insurance to exporters arms exports are of particular value to the British economy and therefore and purchasers of UK equipment at premium rates well below the market deserving of unique support from government. It concludes that rate, an annual subsidy that amounts to £222m. The cost of the distortion government subsidies to arms exporters, worth at least £453m and of MoD procurement to accommodate export promotion is more difficult to possibly up to £936m a year, are based upon false economics. Far from estimate, but if the experience of the Hawk deal is in any way indicative, providing jobs, government support for arms exports diverts investment our estimate of £200m is extremely conservative. away from more effective job-creating economic activity. The only In addition, the report seeks to identify the extent of subsidy to arms significant impact from reducing these exports would be felt by a handful exports that accrues through government contributions to defence R&D. of highly-dependent local economies that would need short-term, targeted The government spends £1.5bn on R&D of weapon systems each year. government assistance to cope with the transition to civil production. On Approximately 40 percent of defence equipment produced in the UK is the other hand, excessive government spending on defence research and exported. Yet last year MoD succeeded in clawing back only £12m of development (R&D) attracts too many skilled workers away from the civil these contributions from the exporting companies. This represents a form sector, thereby exacerbating a shortage in the non-military economy and of subsidy, though there is major disagreement as to how this should be harming prospects for long-term economic growth. calculated, as R&D costs may be partially offset by exports and - some Exports are not an automatic ‘good’: unless they achieve an adequate rate commentators argue - this money would be spent regardless of export of return they are in fact a drain on the economy. Given the level of sales or prospects. If, however, one does assume that 40 percent of R&D subsidy involved and the relatively low profit margins achieved in a spending relates directly to exports (the same percentage of total UK competitive global market it is highly unlikely that arms exports either defence production that is exported), this would give an upper estimate of significantly offset domestic procurement costs or make a positive the R&D subsidy of £483 million. contribution to Britain’s overall economic well-being. In any case, arms We estimate that the subsidies provided to UK companies involved in exports make up only 1.5 percent of the UK’s overall exports, and any defence exports are therefore worth at least £453m and possibly up to reduction in sales is likely to be partially offset by higher civil exports. £936m; in other words, between £7,000 and £14,400 for each job It has been highlighted by recent experience that the desire to promote supported by exports. At a time when public spending is under pressure exports can also have a deleterious influence upon domestic procurement the onus is on the Government to withdraw the subsidies and encourage decisions, thereby weakening value for money and potentially impairing similar withdrawals in other countries. the operational effectiveness of the UK’s armed forces. The recent export of BAE Hawk trainer jets to India and the related decision by the Defence Secretary, Geoff Hoon, to buy Hawk in the face of reported opposition from his own Permanent Secretary and other government departments, clearly demonstrates the erroneous assumptions driving current policy. Internal government estimates reported in the press indicate that export and employment considerations actually added, rather than saved, £1bn to the price tag for the Hawk procurement over the lifetime of the project.
3 4 Introduction Escaping the Subsidy Trap
lowest cost, this policy can lead to poor procurement decisions and higher 1. Introduction costs to the taxpayer. The report also concluded that five years after a 50 percent reduction in UK arms exports “overall national income would be substantially the same as it would otherwise have been without the loss of Tony Blair’s Government has a foreign policy that involves the tightening defence exports,”4 and that “the economic cost of reducing defence of controls on arms exports, yet at the same time it promotes UK arms exports are relatively small and largely one off”.5 Yet, UK Government exports around the world, extolling the economic benefits they bring to the ministers have wildly misinterpreted the York Report’s findings, claiming UK. These benefits purportedly include: retention of skilled employment; erroneously that it concluded, “defence exports represented a significant enhanced balance of trade and other spin-offs to the wider British net benefit to the UK economy”.6 economy; and reduced costs for domestic defence procurement (as follow-on exports result in lower average unit costs of production). It should be noted that the Government does provide non-economic Successive governments have deployed these arguments about perceived justifications for supporting arms exports. For example, there is the economic benefits when justifying their export promotion. Some of these argument that a strong indigenous defence industrial base (which, so the exports might otherwise have been refused for their potentially negative argument goes, requires a strong export performance if it is to be impact on human rights, peace and stability and sustainable development sustained over time) is necessary to safeguard the UK’s security of supply - as set out in the Government’s export criteria and its stated international of defence equipment. However, in a written parliamentary answer in June commitments. 1 This economic justification is further influenced by 2004, Defence Minister Lord Bach appeared to restrict the application of ‘constituency politics’ and the fear that job losses in the defence sector are this argument to “a very small number of capabilities which for national likely to have negative electoral consequences. security reasons we place a high priority on retaining within the United Kingdom industrial base”. The examples Lord Bach gave were “in the Successive UK governments, therefore, have provided financial and fields of nuclear technology, defence against biological, chemical and political support for arms exports. In July 2001 the Oxford Research Group 7 2 radiological warfare, and some counter-terrorist capabilities”. and Saferworld published a report entitled The Subsidy Trap, which Nevertheless, time and again when justifying the merits of arms exports, estimated annual government subsidies to arms exports of at least £420m, ministers continue to frame the debate in terms of economic benefits. or £4,600 for every job involved. A report published later in the same year by independent academics and MoD’s own senior economists entitled This report re-examines the economic arguments for the Government’s Economic costs and benefits of UK defence exports (the ‘York Report’), support for arms exports, and calculates what that level of support is concluded that as the economic benefits are at best insignificant, the “balance of argument about defence exports should depend mainly on non-economic considerations”.3 Furthermore, as the recent decision to 4 purchase the domestically-produced Hawk trainer aircraft for the RAF The Economic Costs and Benefits of UK Defence Exports, op cit, Executive Summary, para 7d, p iv. demonstrates, far from equipping UK forces with the best equipment at the 5 Ibid, para 86, p 33. 6 Lord Bach winding up the debate on the Export Control Bill, Official Report, House of Lords, 8 January 2002, col 515. 7 1 Lord Astor of Hever asked Her Majesty's Government: What technologies in the defence The Consolidated EU and National Arms Export Licensing Criteria (26 October 2000—HCX industry are considered to be critical to national security or imperative for defence capability. 199-203W). 2 Lord Bach replied: The Government's defence industrial policy, published in October 2002, is Ingram P and Davis I, The Subsidy Trap: British Government Financial Support for Arms aimed at enhancing the competitiveness and sustainability of the UK defence industry, while Exports and the Defence Industry, (2001, Oxford Research Group/Saferworld, Oxford). continuing to provide the Armed Forces with high quality equipment at best value for money. 3 Chalmers M, Davies N, Hartley K and Wilkinson C, The Economic Costs and Benefits of UK There are a very small number of capabilities which for national security reasons we place a Defence Exports, (the York Report), York University Centre for Defence Studies, November high priority on retaining within the United Kingdom industrial base. Examples exist in the 2001, para 86, p 33. This was later summarised in: Chalmers M, Davies N, Hartley K and fields of nuclear technology, defence against biological, chemical and radiological warfare, Wilkinson C, ‘The economic costs and benefits of UK defence exports’, Fiscal Studies, and some counter-terrorist capabilities. Source: Official Report, House of Lords, 7 Jun 2004, September 2002, vol 23, no 3, pp 305-342. Column WA9.
5 6 Introduction Escaping the Subsidy Trap costing the taxpayer. In doing so, we are not calling for the defence industry to be closed down, an accusation that is frequently made 2: Myths behind UK Government whenever commentators question Government support for particular arms exports.8 Rather, the contention is that as there is no intrinsic economic support for arms exports benefit in exporting defence equipment, and as the current relationship between domestic and export markets can lead to poor procurement Successive government policy statements since 1997 (including the 1998 decision-making, taxpayers’ money should not be used to provide a Strategic Defence Review, the 2002 Defence Industrial Policy, and most discount to foreign buyers of UK-sourced arms on the grounds that it recently the 2003 Defence White Paper) have reiterated the government’s protects particular jobs or benefits the economy in general. intention to strongly support military exports. The UK Government pursues Defence companies should be expected to operate on a level playing field this assistance in a number of ways, including political and diplomatic aid, collaboration with defence companies through a number of fora (such as with other exporting firms, pursuing export orders without support from 9 government. If defence were not excluded from European Union (EU) and the Defence Export and Market Access Forum) and financial subsidies World Trade Organisation (WTO) regulations for reasons of national (the focus of this report). This section examines the main economic security, much of the current support and concurrent protectionism would arguments that the UK Government uses to justify its support for arms be illegal. Therefore, justifications for the use of public funds to support exports in terms of the retention of skilled employment, the balance of arms exports should depend solely upon national security objectives, on trade and other benefits to the wider economy, and reduced costs for the understanding that these are not used to trump human rights or domestic defence procurement, and explains why the assumptions regional stability concerns. underpinning them are flawed.
The jobs myth
‘The [UK defence] industry is a key part of our economy, contributing significantly to our balance of trade and employment’.10
Protection of defence jobs is frequently the principal public rationale for granting questionable export licences and subsidising defence companies. 8 On 20 June 2002, the Prime Minister Tony Blair was asked: Why do you think you should However, in the context of the size of the UK economy and the flexibility of be taken seriously when you call for a negotiated settlement in Kashmir, when within recent the labour market, it is far from clear that the Government should spend so months your government has been authorising sales of rockets, bombs, missiles to both much to save so few jobs. Of course, the loss of any particular jobs is sides in the conflict? The Prime Ministers response was: “Because the idea that we should significant to the people concerned, but if the concern is to maximise the shut down our defence industry in those circumstances I find absolutely bizarre”. (From Prime Minister’s Press Conference, Downing Street, 20 June 2002, http://www.number- number of high-quality jobs, defence export support is a highly inefficient 10.gov.uk/output/Page2999.asp.) choice.
9 Written Parliamentary Answer ‘Defence Export and Market Access Forum’ by Adam Ingram, MP, Minister of State, Ministry of Defence, to Michael Hancock, MP, Official Report, 30 June 2004, Col 350W. 10 Foreword by Lord Bach, Under Secretary of State, MoD, and Alan Johnson, MP, Minister of State, Department of Trade and Industry, to the Defence Industrial Policy, published at http://www.mod.uk/issues/industrial_policy.htm.
7 8 Myths behind government support Escaping the Subsidy Trap
Defence Industry Employment Trends exports therefore constitutes 0.25 percent of the national labour force, and Direct and indirect employment in the UK defence industry arising from less than two percent of that in manufacturing. MoD procurement and from exports, according to official statistics The debate over government intervention in supporting employment in published by DASA.11 particular sectors has evolved considerably since the 1970s. The 000s jobs prevailing view held by the vast majority of economists and by recent 500 governments is that intervention in the labour market should be minimised, Exports thereby enabling a more flexible labour market to respond to changes in 400 Mo D supply and demand. According to the Treasury, “flexibility in labour... is
300 critical to ensuring that firms and individuals can adapt... and thrive in a globally competitive economy”.16 More than a quarter of the workforce in 17 200 the private sector now moves to a new job every year. Almost half a million people leave the unemployment register for a job each quarter.18 100 But the development of labour market policy appears to have passed the 0 defence industry by. This is curious given the commitment of recent British 6 1 6 8 9 0 1 2 5/ 0/ 5/ /9 8/ /0 0/ 1/ governments to cut industrial subsidies and to concentrate scarce public 8 9 9 97 9 99 0 0 resources where its impact is greatest. Both history and the relative figures Impacts on UK employment strongly suggest that significant losses in defence jobs could easily be accommodated within the overall labour market, much as has happened in According to official UK Defence Statistics, the total employment the last twenty years as a result of the contraction of the industry. supported by Britain’s defence equipment industry has reduced from Indeed, the York Report concluded that a halving of exports would result in 470,000 in 1985 to around 200,000 today.12 This accounts for 0.7 percent the loss of 49,000 jobs in the defence sector, but that this would be more of total UK employment, and less than six percent of those employed in than offset by the creation of 67,000 new jobs elsewhere in the economy. manufacturing alone.13 Within the overall figure of 200,000 the Although many of these replacement jobs were likely to be at a lower skill Government estimates that those employed on arms exports account for level, they would be helping to meet shortages currently within the civil 65,000 UK jobs,14 of which around half are generated directly, and half economy. This conclusion is supported by a study on skills deficiency indirectly through the supply chain.15 Employment dependent on arms within England, from the Department for Education and Skills, which highlights the skills shortage in the craft-intensive construction and 19 11 UK Defence Statistics 2003, op cit, table 1.13. manufacturing industries, in particular. 12 UK Defence Statistics 2003, Defence Analytical Services Agency (DASA) (Civilian & Financial), table 1.9. Note that we use MoD equipment expenditure to identify the defence industry, to separate this from other employment arising from MoD spend outside of the generated in those companies providing the product or service directly to the customer. defence industry. ‘Indirect employment’ refers to employment in the supply chain sourced from a prime 13 contract. See July 2003 edition of Labour Market Trends, Table A1, at: 16 http://www.statistics.gov.uk/downloads/theme_labour/LMT_July03.pdf. Manufacturing Flexibility in the UK Economy, HM Treasury, March 2004. Can be found at: http://www.hm- employment is at: Table B.12. treasury.gov.uk/media/22EE0/flexibility_report_264.pdf#page=3. 17 14 UK Defence Statistics 2003, op cit, DASA (Procurement), Table 1.9. It is difficult to come to See Labour Market Trends, November 2003, figure 9, p 549, available at: an accurate figure for the total number of jobs dependent upon arms exports because some http://www.statistics.gov.uk/downloads/theme_labour/LMT_Nov03.pdf. equipment can have both military and civilian purposes ie the equipment is dual-use. 18 Labour Force Survey 2003, Office of National Statistics. 15 Here we use official terminology, which contrasts with economic terms (usually used to 19 Terence Hogarth and Rob Wilson, IER, ‘Skills Matter: a synthesis of research on the distinguish employment directly connected with the industry with that created by spending extent, causes and implications of skill deficiencies’, Department for Education and Skills, associated with the economic wealth generated). ‘Direct employment’ refers to employment Brief No: RBX 19-01, October 2001. Summary page 3, available at:
9 10 Myths behind government support Escaping the Subsidy Trap
Since the years taken as baseline by the York Report, UK employment In 1997 the Government established the Prestwick Taskforce to “assist in dependent upon defence exports has already almost halved. However, the economic development of Prestwick in the light of recent job losses” this has had a negligible impact on unemployment and the UK economy. (650, to be precise).24 The taskforce operated until December 1998, by The impact of the downturn in defence expenditure during the 1990s upon which time the Government announced that 90 percent of the people laid employment was of a greater order than any further possible reduction in off by British Aerospace had secured alternative employment locally, and arms exports, yet any significant impact was limited to a handful of local 600 additional jobs in the area had been created.25 economies. Employment in innovation Regional and local impacts ‘The UK’s innovative science base supports the defence industry’s It is not possible to determine the level of regional employment dependent high levels of technology development, and this brings benefits to on defence expenditure because official statistics are too unreliable,20 but other industry sectors through the application of military technology we do know that it remains concentrated in specific regions.21 The most to civil products…’ 26 recent comprehensive study of this issue, by Ian Goudie in 2002, demonstrated that only three regions: South East, South West and the As part of its longstanding policy of supporting the British defence North West would be likely to experience any immediate measurable rise industrial base, the UK Government spends £2,057m on military research in unemployment as a result of reduced arms exports and that, in any and development (R&D), which equates to 32 percent of its military 27 case, this would be small and short-lived.22 procurement spend within the UK. Traditionally, it has been argued that defence R&D spending produces significant beneficial spin-offs to the civil Similarly, there are only a handful of local economies particularly sector, and, therefore, that the military is one of the most cost-effective dependent upon defence exports. Schemes provided by companies or recipients of public R&D funding. However, while technology development government designed to mitigate the employment impact of defence cuts in the defence sector does still have occasional application elsewhere, this by helping people find new work, providing business start-up advice and argument has now largely been reversed. For at least the last two early retirement packages and re-training schemes, can prove extremely decades, the civil sector has been the driving force in terms of effective.23 Such initiatives include the Defence Diversification Agency technological advances, for example, in communications technology. Civil (DDA), the Partnership at Work Fund, and the Rapid Response Service. Regional Development Agencies are also mandated to advise on strategies of support for those leaving declining industries. 24 http://www.publications.parliament.uk/pa/ld199798/ldhansrd/vo980212/text/80212w03.htm 25 http://observer.guardian.co.uk/business/story/0,6903,564445,00.html. In 1999 Sandra Osborne, MP for Ayrshire, stated in Parliament: “The task force set itself eight targets. They have all been fully achieved or are well on the way to being achieved and have been picked http://www.dfes.gov.uk/research/data/uploadfiles/ACF1874.doc. A shortage of skilled labour up by other bodies. Alternative employment has been found for the majority of Jetstream for the defence industry reflects a general shortage of key skills in the economy as a whole. workers affected by the closure, and all 270 aerostructure jobs at British Aerospace, which See 2003 Defence White Paper, Supporting essay 7, ‘Making Defence Industrial Policy Work were at risk, have now been secured. In addition, more than 600 jobs have been created or for the Armed Forces and UK Industry’, para 7.7. are planned for the Prestwick area.” Official Report, House of Commons, 21 January 1999, 20 See Turner, Chalmers and Hartley, ‘Defence Statistics Bulletin No. 5’, Defence Analytic col 1099. Can be found at: http://www.parliament.the-stationery- Services Agency, March 2003, p v. office.co.uk/pa/cm199899/cmhansrd/vo990121/debtext/90121-26.htm 26 21 See Morgan B, Defence Employment: 1996-97, House of Commons Library, March 1999. The UK Defence Industrial Policy 2002, Foreward, authored by Lord Bach, Minister of State for Defence Procurement & Alan Johnson, Minister of State for Employment Relations, 22 Goudie I, The Employment Consequences of a Ban on Arms Exports, Campaign Against Industry & the Regions. Available at http://www.mod.uk/issues/industrial_policy.htm the Arms Trade, September 2002, p 16. 23 Ibid, p19. Following the closure of Vicker’s Challenge II tank factory in Leeds in 1998, 80 27 Defence Statistics 2003, op cit, R&D budget, Table 1.7. Procurement budget extracted percent of the workers achieved a ‘positive outcome’ within the twelve-month multi-agency from Table 1.8 amounts to £6.4m (separated from services, fuel, administration and other redeployment programme. equipment running costs).
11 12 Myths behind government support Escaping the Subsidy Trap technology development is more rapid and responsive to market on the economy unless the exporter receives an adequate rate of return; a pressures. With long lead-times and the often-consequent use of highly debateable proposition in the defence sector, which is a buyers’ redundant technologies, along with a greater emphasis upon reliability, the market and when so many subsidies are involved. Yet Government defence sector has become a great deal less relevant to innovation. thinking on this matter appears to be rooted firmly in the past, assuming that if arms exports contract, then the inputs that would have gone into Government support for innovation should target growth sectors, such as that production will simply be lost to the economy. renewable energy and biotechnology.28 Support for defence R&D pulls away highly-skilled personnel from more productive sectors, limiting the contribution towards economic growth. Defence Exports as a Percentage of Overall UK Exports31
3.5 The balance of trade myth 3 2.5 The Government has also sought to justify support for arms exports on the 2 grounds that they are significant for the wider economy, in terms both of 1.5 their scale and their contribution to the balance of payments and national 1 income. In 2002, the gross UK arms exports revenue of £4,120m 0.5 amounted to only 1.5 percent of total UK exports.29 0 This gross figure may overestimate the benefit to the national balance of 1990 1995 1997 1998 1999 2000 2001 2002 payments, given that a high percentage of the components incorporated within exported systems originated as imports (a percentage that has This type of approach would also appear to be behind a recent report increased significantly in recent years with the globalisation of the commissioned by BAE Systems, which referred to the contribution the industry’s suppliers). Despite the unusual level of government support company made in terms of numbers of people employed, the amount of received by defence exporters, their share of total UK exports has private investment, the total level of exports, the corporation and income consistently reduced. tax contributions to the Exchequer and the level of R&D spent. However, this failed to take into account the net costs and benefits if that capital The Government’s assertion that the export of arms is automatically good 32 for the economy is also open to question. The mercantilist pursuit of were deployed elsewhere. exports as an end in themselves has long been discredited. As the In a modern mixed economy, as one industry contracts the capital respected financial journalist, Sir Samuel Brittan, has observed: “Export drives really amount to the diversion of public resources towards special 30 interest groups under the guise of patriotic slogans.” Exports are a drain 31 Ibid, and National Statistics, Balance of payments - Trade in services 1955 – 2003 and Trade in goods 1955 – 2003 (constant prices), can be found at National Statistics website: http://www.statistics.gov.uk/CCI/nscl.asp?ID=5819. 32 28 ‘The Economic Contribution of BAE Systems to the UK and Implications for Defence The latest Congressional Research Report appears to suggest that a long-term decline in Procurement Strategy’, (Oxford Economic Forecasting, January 2004). This report lists the global transfers of weapons continues. See analysis on BASIC’s website: contributions of BAE to the UK economy. There is no dispute that the jobs created by http://www.basicint.org/WT/wtindex.htm. 29 defence equipment purchases are highly capital intensive, so that productivity per employee See Defence Statistics 2003, op cit, table 1.13. These figures are based upon Society of and R&D spend are likely to be impressive on the surface. However, without any indication of British Aerospace Companies and could be on the high side. alternative applications for the investment and skilled labour tied up in BAE Systems, there is 30 Samuel Brittan, ‘Weapons Exports: The bogus moral dilemma’, World Economics, vol 4, no no way of putting the figures in any context sufficient to give an indication of the benefits of 2, April-June 2003. BAE operations within the UK.
13 14 Myths behind government support Escaping the Subsidy Trap released is re-deployed elsewhere in the economy, while long-term by protected domestic defence markets. imbalances in the UK current account are addressed automatically by changes in the exchange rate. As a consequence, the long-term impact on • Defence exports are highly unpredictable in advance of the economy overall of a drop in defence exports would be negligible. The investment in, and development of, the system, and tend to York Report estimated that were exports to fall by 50 percent, “at the end lengthen the life of production lines rather than the scale (so that of the five year period, overall national income would be substantially the some economies are lost). same as it would otherwise have been without the loss of defence exports”.33 Adair Turner, former Director General of the CBI, is similarly • Many ‘fixed costs’ are not fixed, and actually vary with the scale of unimpressed by the difference arms exports make to the economy, production. This makes sense in managerial terms in that the calculating that if they were to fall by 35 to 40 percent, this would have the scale determines the revenue (or expected revenue), which in turn effect of merely stalling GDP growth for six weeks.34 determines the level of investment in so-called fixed costs. • MoD procurement rules inadvertently allow some level of cross- subsidy for marketing, servicing and risk abroad (in that costs are The cheaper defence procurement myth shared as a proportion of production even when the costs of selling abroad are greater).
A thriving, innovative and competitive defence industry is essential Systems developed for domestic use are frequently inappropriate for world for the defence of the UK. It is the primary source of world-class markets, and require significant re-design and re-tooling (thus losing some equipment for our Armed Forces… the Government’s new defence of the scale benefits). Furthermore, the knowledge that different buyers industrial policy [is] aimed at enhancing the competitiveness and have different requirements can skew R&D and even UK procurement sustainability of the UK defence industry, while continuing to provide itself. Occasionally, the pressure to sell overseas and the greater 35 high quality equipment at best value for money. competition in export markets can result in the export ‘tail’ waving the procurement ‘dog’, with the designs of systems for domestic use being The Government sometimes defends its support for arms exports on the geared more towards export needs, or domestic orders being placed on basis that foreign sales drive down unit costs of production and MoD’s the grounds that they will help secure exports. This, of course, is exactly equipment bill. This ‘economies of scale’ assumption appears to be based the opposite intention of providing subsidies. It is graphically illustrated by in part on the premise that domestic sales will precede exports and that all the recent case involving the purchase of the Hawk trainer aircraft for the customers will be satisfied with the same finished product. The reality is Royal Air Force (RAF). MoD may have paid £1bn too much, and possibly frequently more complicated, both in terms of the timing of sales and the purchased the wrong aircraft in order to secure a sale of similar aircraft to specifications of the different buyers. In addition, there are a number of India (discussed further in section 2). In this case, any benefit possibly other reasons to question the extent of any cost savings. acquired from reduced MoD overheads is offset more than several times • As the world market in arms is so competitive, exports are over by the costs of the distorted decision designed to boost export frequently sold near the marginal cost of production, with suppliers prospects. competing against each other after their fixed costs are covered If the argument that export sales lower the costs of domestic procurement comes under question, then so too does the notion that this is a rational 33 basis for subsidising arms exports. When one takes into account the The Economic Costs and Benefits of UK Defence Exports, op cit, Executive Summary, para 7d, p iv. impact that the drive to export can have on the quality or relevance of MoD 34 Adair Turner, Just Capital: The Liberal Economy, (London, Pan Books, 2001), p 362. purchases and on the overall cost to the taxpayer, it would seem that such 35 The UK Defence Industrial Policy 2002, Foreward, authored by Lord Bach, Minister of a policy can be positively harmful, in both economic and operational terms. State for Defence Procurement & Alan Johnson, Minister of State for Employment Relations, Industry & the Regions. Available at http://www.mod.uk/issues/industrial_policy.htm. Some commentators justify support for subsidies for strategic-industrial
15 16 Myths behind government support Escaping the Subsidy Trap reasons, to avoid over-dependence upon a single monopoly supplier (in the United States).36 While a policy of buying ‘off the shelf’ may present 3: Case study: Hawks to India… superior value for money, better equipment for the armed forces, and a higher level of inter-operability with allies, some believe it may expose A £1bn subsidy? future UK defence acquisition to the whims of foreign manufacturers.
Two factors weaken this argument. First, it is no longer meaningful to talk of a British defence industry per se, as ownership and production facilities Introduction do not now respect national boundaries, and those companies that are In September 2003 BAE Systems secured a contract worth £1bn with the located in Britain source many of their components from abroad. Second, Indian MoD to sell 66 Hawk jets - 24 of which are to be delivered to India responsible for almost 50 percent of global defence spending, well over fully complete while the remaining 42 will be built under licence by half of global military equipment spending, and an even greater proportion Hindustan Aeronautics Limited in India.37 Despite stiff competition from of military R&D, the US is the determining market for successful defence Czech-US (jointly), Italian and Russian rivals, the contract was awarded to companies. Companies without clear access to the US market are frozen BAE Systems - eight years after the initial tenders were issued. out of any realistic competition in all but a handful of the most specialised military technologies. An alternative approach could be to turn to Europe However, this deal was flawed on many grounds. The UK Government’s for economies of scale. However, this would involve significant political and financial support for the deal undermined its own criteria on collaboration costs. arms exports and cost the taxpayer dearly both in terms of the cost of promoting the deal and the estimated £1bn subsidy cost of procuring In light of the requirements outlined in the Defence White Paper in Hawk aircraft for the UK military, which was linked to the India deal. December 2003, which are presently under review, the alternatives need further consideration and debate. MoD's stated policy of balancing value for money with ensuring future diversity of supply is sensible, but does not Government support for the deal justify support for British companies specifically. From the outset, the UK Government actively supported the BAE tender. Lobbying was undertaken in a series of visits by the Defence Secretary, Foreign Secretary, Deputy Prime Minister and most notably in reciprocal visits involving the Prime Minister himself. According to press reports, when Tony Blair met the Indian Prime Minister, Atal Bihari Vajpayee in October 2002 at the height of the Kashmir crisis, he lobbied strongly on behalf of BAE’s Hawks.38
The Quadripartite Committee39 of the UK House of Commons later expressed concern that such lobbying could have a prejudicial outcome on any licensing application for the sale of the Hawks. It recommended that
36 There is also a fear that over-dependence would have implications for security of supply in times of crisis, or for being dependent upon sources that could be cut off for political or proliferation reasons. 37 David Gow, `5,000 jobs safe as India buys Hawks`, The Guardian, 26 July 2004. 38 Richard Norton-Taylor and Ewen MacAskill, `£1bn arms push to India`, The Guardian, 19 July 2004. 39 The QSC comprises the Defence, Foreign Affairs, International Development and Trade & Industry select committees. Its role is to scrutinise the British Government’s arms export licensing regime.
17 18 Hawks to India Escaping the Subsidy Trap
“before any minister becomes personally involved in promoting the sale of The UK Government demonstrated its support for the aircraft when it defence equipment abroad, the Government should consider the proposed decided to buy the Hawk for the RAF. In July 2003 it signed an £800m export in question against the consolidated criteria with as much care as it deal with BAE Systems for the purchase of 20 Hawk trainers and the would an export licence application”.40 option on a further 24 for the RAF. The fact that this would help secure the BAE tender in India appears to have been a strong motivating factor in Ministers claimed that the deal did not contravene criterion 4 (regional that decision, as it provided evidence to the Indian Government of the peace, security and stability) of the consolidated criteria, as the Hawk is a British Government’s faith in the aircraft and that it had a long-term future. trainer aircraft.41 This conveniently overlooks the fact that Hawks can be refitted as fast ground-attack aircraft, as the Indonesians are reported to This contract between BAE Systems and UK MoD for the Hawk is said to have done during their repression of the East Timorese.42 The Hawks are be worth £3.5bn over 25 years.44 On signing this agreement the Defence also ideal for Kashmir’s mountainous terrain because of their size, speed Secretary Geoff Hoon said: and manoeuvrability. Furthermore, as the Hawks are likely to be used to train pilots to fly aircraft capable of carrying a nuclear payload (such as, for Hawk 128 is an excellent aircraft. It is the right choice for training example, India‘s UK-supplied Jaguars), their export would appear to be the pilots of our future advanced fighter jets and the right decision inconsistent with the UK’s counter-proliferation goals in South Asia. for our defence industrial capability. This is excellent news for BAE Systems, its employees at the Brough factory on Humberside, The case highlights the inherent conflict of interest that exists as a result of where Hawk 128 will be designed and built, and for the several the dual role of the Government as a regulator of arms exports and hundred people involved in the UK supply chain for the aircraft. promoter of UK exports. If Ministers have already lobbied hard on behalf of the sale, they are hardly likely to refuse an export licence. In a letter to his own Permanent Secretary justifying his decision he stated: An order for a new advanced variant of the successful Hawk aircraft Distorted acquisition would support our high technology aeronautical capability, including skilled jobs and assist future exports of Hawk variants. 45 In the face of criticism of its support for the Hawk deal, the UK Government returned to the stock defence of British governments over the Despite the Defence Secretary’s assertions of the benefit to jobs, the years: it argued that the deal was economically beneficial to the UK. A economy and domestic procurement, the £3.5bn deal was reported to spokesperson for the Prime Minister said, ‘we make no apology for have faced severe criticism from within the Treasury and MoD. First, as supporting a legitimate defence industry’.43 the deal was not opened to tender, it was impossible to negotiate a better deal with BAE or another supplier. Second, the Hawk is an aircraft built using 30-year-old technology and according to an internal UK MoD assessment would be unable to ‘maintain its present tasks beyond 2006’.46 Alternative aircraft were not only cheaper, but also in some respects more 47 40 technologically advanced. For example, the Italian Aermacchi 346 is Strategic Export Controls Annual Report for 2001, Licensing Policy and Parliamentary Scrutiny, Second Joint Report of the Quadripartite Committee, House of Commons, HC474, 20 May 2003. 41 The criterion states: ‘The Government will not use an export licence if there is a clear risk 44 that the intended recipient would use the proposed export aggressively against another ‘Hawk 128 the right choice for new jet trainer – Geoff Hoon`, MoD, Defence Procurement country or to assert by force a territorial claim’. Annex F: The Consolidated EU and National Agency, 9 July 2004. Arms Export Licensing Criteria, United Kingdom Strategic Export Controls Annual Report 45 David Hencke, `MoD chief refused to sign £800m Hawk order`, The Guardian, 5 July 2003, pp491-494. 2004. 42 Ryan Dilley, `The `trainer` jet the UK loves to Hawk`, BBC News, 8 September 2004. 46 Clayton Hirst, `MoD’s £6bn sweetener for BAE`, The Independent, 20 July 2004. 43 Jean Eaglesham and Edward Luce, `Anger as Blair uses Kashmir talks to sell Hawk jets’, 47 These included the L-159B a Czech-American jet made by Aero Vodochy, the Italian The Financial Times, 22 October 2002, p 6. produced Aermacchi 346 and the Russian built MiG-AT. The MiG-AT was at least $5m
19 20 Hawks to India Escaping the Subsidy Trap
cheaper and technologically superior to the Hawk, in that it possesses ‘fly- by-wire’ computerised technology, a desirable feature for pilots training to 4: The Subsidies fly the Eurofighter and Joint Strike Fighter.
According to press reports in July 2003, the purchase of the Hawk aircraft We have identified three broad categories under which we have allocated is likely to cost MoD at least £1bn more for trainer aircraft over the lifetime the types of financial support the UK Government provides for military of the deal than would have been the case if it had bought the Aermacchi exports: 48 346. This at the time when, according to recent press reports, MoD “is so • Direct assistance to defence manufacturers in exporting short of cash that it is axing investment in playground equipment for the abroad; children of service personnel [and] scrapping orders for power showers in 49 • Export credits; barracks”. The jobs of 2,200 employees at the BAE plant at Brough in East Yorkshire are said to have been directly secured by the deal, • MoD’s procurement policy. although the total number of jobs at stake is likely to be in the region of 4,000 to 5,000.50 The overspend of £1bn, therefore, works out at a subsidy In addition, we have allocated a proportion of the funds provided by the of £200,000 to £250,000 per job. Indeed, Sir Kevin Tebbit, Permanent Government in support of military R&D as comprising a subsidy for Secretary at MoD (the department’s most senior civil servant), refused to exports. This figure has been treated separately as there is considerable sign off the deal because of value for money concerns. Such a decision is disagreement among experts as to whether this subsidy can be applied to rare, and is only taken when a Permanent Secretary is convinced that a defence exports per se. On the one hand, exports do take a proportion of ministerial decision may infringe upon the ‘propriety’ or the ‘economy, the government military R&D spend; but on the other hand, revenue from efficiency and effectiveness’ of the department in which they work.51 Geoff exports may cover some of the R&D costs, thus reducing the price to MoD Hoon was forced to overrule his Permanent Secretary - a decision that has of their own procurement, and it is sometimes argued that these funds since been referred to the National Audit Office (NAO) and the Commons would in any event be made available for military R&D, regardless of Public Accounts Committee.52 export orders.
Evaluating the precise extra cost and the impact on performance caused One of the biggest challenges in calculating the support for arms exports by MoD’s favouring one supplier over another in such a large and is separating it from spending on other military and broader foreign policy technically challenging procurement is inevitably difficult. However, given activities (as stated at the outset). For example, military assistance and the reported concerns of the Treasury and the unusual actions of the training provided to other countries can be motivated by strengthening Permanent Secretary, irrespective of the exact cost, it is clear that the military capability of allies, security sector reform, strengthening strategic Government is willing to provide multi-million pound subsidies in order to and diplomatic ties, or simply encouraging the sale of British equipment. secure jobs and exports in the face of evidence that such a decision may More often than not it is a complex combination of these objectives. We be deeply flawed. attempt here to focus exclusively on government support explicitly for export promotion.
Wherever possible, we have used information in the public domain. However, inevitably there are areas where we have been forced to form a cheaper per jet than the Hawk. reasonable estimate of support based on incomplete data. 48 Mary Fagan, `How the Hawk fought off an Italian predator`, Daily Telegraph, 19 July 2004. 49 David Hencke and Richard Norton-Taylor, ‘Service families suffer as arms bills soar’, The We calculate that total subsidies to arms exports are at least £453m, and Guardian, 6 September 2004. possibly up to £936m, broken down as follows: 50 David Gow, `5,000 jobs safe as India buys Hawks`, The Guardian, 26 July 2004 51 David Hencke, `MoD chief refused to sign £800m Hawk order`, The Guardian, 5 July 2004. 52 Ibid.
21 22 The Subsidies Escaping the Subsidy Trap
Summary table of UK arms export subsidies procurement and logistics; • providing assistance on offset and financing schemes; £million • organising military equipment demonstrations and training; & DESO 14 Defence attaches 6 • organising visits to the UK by senior government and military Use of armed forces for promotion 6 personnel from overseas. DAF 5 The net operating budget for DESO for 2004-5 is £14.4m.55 This includes Direct assistance 31 income received for the sale of surplus MoD equipment, and a small Export credits 222 amount as fees charged to exporters. The government has rejected calls MoD procurement distortion 200 for DESO to be privatised, believing its value stems from its integration with MoD. However, this creates a situation where the same department Total 453 responsible for getting best procurement value-for-money and for Support for development of systems up to 483 assessing export licence applications, is also charged with assisting arms Grand total up to 936 exports. On occasion this will provide for significant conflict of interest. DESO effectively operates as a defence industry lobby within the department. Direct assistance: £31m subsidy Defence exporters derive additional benefit from the services offered by UK Trade and Investment (formerly British Trade International), which “bring[s] together the joint work of the FCO and DTI in support of British Defence Export Services Organisation (DESO): £14m trade and overseas investment”. This support is, however, provided across the board to UK exporters. By contrast, the assistance provided by DESO As a central unit in the UK Ministry of Defence, our mission is to is uniquely available to the defence industry alone. maximise legitimate UK defence exports in coordination with Industry. 53 Defence Attachés: £6m DESO was established by the Labour Government in 1966 in response to a sharp decline in the UK’s share of world aircraft markets, to “assist the Support of the Defence Export Sales [sic] Organisation (DESO) is defence industry in securing overseas orders”.54 It provides a range of one of the core functions of an attaché. However, the priority given in services, including: their job description varies according to the export prospects in the host country. 56 • bringing overseas customers and UK suppliers together; • undertaking procurement as agents on behalf of overseas A defence attaché’s job description includes: the development of bilateral governments; defence relationships; advice to the Ambassador or High Commissioner; • assisting industry and foreign governments in acquiring UK representing the British military and working to MoD instructions; and export licenses; supporting DESO in its efforts to promote military exports. • providing professional military support on doctrine,
55 Adam Ingram, MP, Minister of State, MoD, in response to Malcolm Bruce, MP, Official Report, House of Commons, 29 Jun 2004, col 176W. 53 DESO’s mission statement is on their website at: http://www.deso.mod.uk/ 56 John Spellar, MP, Minister of State, MoD, in response to Austin Mitchell, MP, Official 54 http://www.deso.mod.uk/origin.htm Report, House of Commons, 28 November 2000, PQ 642W.
23 24 The Subsidies Escaping the Subsidy Trap
The Defence Manufacturer’s Association (DMA) states in its promotional financial years has been £2m.61 In an answer to a parliamentary question materials: regarding the estimated cost to the UK Government of the Defence Systems and Equipment International exhibition, held in London in 2003, Overseas Defence Attachés – these are briefed regularly on the UK the Defence Minister Adam Ingram replied that “the direct cost to the defence industry and they are invited to DMA events to help Ministry of Defence identified centrally is estimated at some £400,000”, 57 develop networking opportunities and contacts. and that “[i]n addition, representatives of [the] Government may carry out
58 activities associated with the exhibition, as part of their normal duties, According to MoD, defence attachés cost £28.7m in 2001-2, with an which could be identified only at disproportionate cost”.62 The Royal Navy additional cost for administrative, office and residential accommodation (RN) and RAF also play a role in terms of demonstrations and marketing of £14m, making a total of £42.7m. An NAO Report in 1989 estimated exercises. For example, ‘Defence Industry Days’ are frequently held on that an average of 40 percent of defence attachés’ time was spent 63 board RN ships as part of the Fleet visit programme. However, the costs directly or indirectly promoting defence exports.59 However, a of these activities are not available. On the assumption that the use of the parliamentary answer from June 2004 states “defence attachés devote navy and air force for export promotion are likely to each comprise no less about ten percent of their time annually to supporting legitimate defence a cost than support for land systems (which would seem a conservative exports and defence procurement collaboration activities”.60 It is not approach), we have a very conservative estimate of a total subsidy of clear from this answer whether it takes into account indirect promotion £6m. (as was explicitly stated in the earlier NAO Report). It would be surprising if the time spent by defence attachés on export promotion had indeed been cut to only a quarter of its original level in those 14 Defence Assistance Fund (DAF):64 £5m years, particularly as the market today is now more competitive. Thus, for the purposes of this subsidy calculation we use a conservative figure The Defence Assistance Fund (DAF) ‘subsidises the cost of military of 15 percent of total defence-attaché budgets allocated (ten percent assistance in support of Defence Diplomacy and Support to Wider direct, five percent indirect), which produces a figure of over £6m. British Interests… Defence Missions… and includes support to Britain’s defence exports’.65 According to Defence Minister Adam Ingram in response to a parliamentary question in June 2004, DAF expenditure in Use of the armed forces for promotion: £6m support of defence exports averaged £5m over the last three financial years.66 The armed forces are called upon to support export promotion in a variety of ways, including by demonstrating equipment at arms fairs and exhibitions. ‘Export Support Teams’ were established in 1984 to demonstrate British land equipment at defence equipment exhibitions and 61 Adam Ingram, MP, Minister of State, MoD, in response to a parliamentary question by shows, and to provide private demonstrations on-site to prospective Michael Hancock, MP, Official Report, House of Commons, 30 June 2004, col 350W. buyers. The average net operating costs of these teams for the last two Previous years have been recorded in a different manner and cannot be compared. 62 Adam Ingram, MP, Minister of State, MoD, in response to a parliamentary question from Jeremy Corbyn, MP, Official Report, House of Commons, 20 May 2003, col 675W. 63 See Dr. Lewis Moonie, MP, Parliamentary Under Secretary of State for Defence, in 57 See, http://www.contracts.mod.uk/dc/public/newsroom/vol1x13/DMAFeature070503.pdf response to a question from Mark Todd, MP, Official Report, House of Commons, 16 58 Adam Ingram, MP, Minister of State, MoD, in response to Lynne Jones, MP, Official November 2000, col 741W. Report, House of Commons, 2 July 2002, col 231W. 64 Previously the ‘Defence Military Assistance Fund’. 59 National Audit Office (NAO), Ministry of Defence: Support for Defence Exports, HC 303 65 Adam Ingram, MP, Minister of State, MoD, letter in response to a parliamentary (London: HMSO, 10 April 1989). question by Dr Vincent Cable, MP, 9 October 2002 (placed in the Library of the House of 60 Adam Ingram, MP, Minister of State, MoD, in response to a parliamentary question by Commons). Malcolm Bruce, MP, Official Report, House of Commons, 30 June 2004, col 350W 66 Adam Ingram, MP, Minister of State, MoD, in response to a parliamentary question by (emphasis added). Michael Hancock, MP, Official Report, House of Commons, 14 June 2004, cols 637-8.
25 26 The Subsidies Escaping the Subsidy Trap
Export credits: £222m subsidy (see appendix) estimation of the sovereign risk. The credit derivatives market is a direct alternative for exporters to offset the risk of export contracts. Where this facility exists, there is no compelling reason for the Government to Put simply, UK-based companies can buy insurance against non-payment continue to offer ECGD support. by their foreign customers from the Export Credit Guarantees Department (ECGD) for less than if they were to buy this service on the open market. It Only a small proportion of ECGD guarantees by value support deals that is this discount that we use to estimate the subsidy to the exporting the private financial markets are unwilling to cover because the risk is companies. In addition, ECGD offers Fixed Rate Export Finance (FREF) to judged too high for a realistic premium. This does not in itself indicate a exporters at a guaranteed fixed exchange rate. As with credit insurance, market failure, so much as a market where demand at the market price is the financial markets offer equivalent instruments to hedge interest rate 67 close to zero. If there are political and social reasons for supporting the exposures. export of particular technologies it would be more transparent, accountable and efficient simply to provide a grant to such activities. ECGD has become a useful tool for governments to subsidise the exports of a relatively small number of well-connected companies; around a third Under sustained pressure in this debate over subsidies, the Government to one half of ECGD support is devoted to military exports. While its 68 has itself just acknowledged that ECGD provides a real subsidy, though mission statement mentions the wider UK economy, it is clear from their estimates of the level have yet to be finalised. A preliminary figure of repeated communications with ECGD officials that it interprets its mission £120m was announced in July 2004 in the Ministerial Statement as simply to promote UK exports. supporting the establishment of the ECGD’s Trading Fund.70 But the Government has also announced that for the time being it intends to This approach runs counter to the general thinking behind current maintain premium rates at existing levels, ensuring the continuation of the Government economic policy, which is based on the belief that the private subsidy. sector is the best vehicle to finance many areas of the domestic public sector such as health, housing and transport (as represented by, for 69 Here we provide a simple estimate of the level of ECGD subsidy to military example, Private Finance Initiatives and Public-Private Partnerships). exports. Our subsidy calculation compares the premiums charged by There are several mechanisms that have been developed within ECGD with those in the financial markets. Claims that the Government is international finance markets that companies can use to take up credit in a better position to offer cheaper rates are not credible; if it were true guarantees to cover their exports. Emerging-market bonds demonstrate then it would be rational for it to generate a profit by undercutting the the level of return the market demands when loaning to foreign finance markets. Using a figure of 3.5 percent as an estimate of the governments. The difference between the rate offered by the market to UK average risk premium on military contracts covered by ECGD,71 and an Government bonds and those to emerging markets reflects the market additional one percent contract risk (based upon the physical export as opposed to the financing), we calculate that the risk premium on ECGD’s military cover, amounting to over £5,000m, is £225m. From this we deduct 67 In 2001 the estimated daily world turnover in exchange traded and ‘Over the Counter’ derivatives was over $4 Trillion, and the notional amounts outstanding approximately $100 Trillion. Bank for International Settlements (March 2002) “Triennial Central Bank Survey: 70 Ministerial Statement, 30 June 2004: “The Government has charged ECGD to continue Foreign Exchange and derivatives market activity in 2001”, p.15 and 18. pricing to break-even, in line with international agreements on export credit, not to maximise 68 “To benefit the UK economy by helping exporters of UK goods and services win business profits. The Government estimates the economic cost of this commitment to be and UK firms to invest overseas, by providing guarantees, insurance and reinsurance against approximately £120 million per annum, and will be publishing budgeting arrangements for loss, taking into account the Government’s international policies”, ECGD Annual Report this in the 2004 Spending Review.” Available on ECGD website: 2001-2, p 4. http://www.ecgd.gov.uk/news_home.htm?id=6213 69 It may or may not be accidental that the one common theme that the ECGD has with such 71 This figure of 3.5 percent is of course notional. To obtain an accurate figure one would schemes is that they enable the Government to receive monies now (whether capital sums or have to take the risk premium offered on the finance markets (through emerging market insurance premia) in return for a promise to return significant resources to the private sector bonds or more directly through credit derivates) on the particular sovereign risk accepted in at a later date. the contract on the day. The overall subsidy would be the sum of all the risks entered into.
27 28 The Subsidies Escaping the Subsidy Trap
£38m in premium received, to reach a figure of £187m. To this we add desire to keep the BAE Systems plant open and to secure the contract £35m for FREF subsidies to reach a total figure of £222m for ECGD’s with the Indian Government, then the subsidy consequences are support to military exports (see appendix for further details of these remarkable. The lifetime of the domestic project is 25 years, which calculations). generates an average £40m annual subsidy in MoD procurement distortion for these decisions alone.
The UK procurement and servicing of Hawks (£3.5bn over their lifetime) Distortion of MoD procurement: £200m subsidy represents only 1.75 percent of total UK defence equipment procured from domestic sources,75 and the sale of the Hawks to India is likely to make up This report has already highlighted the risk that pursuit of export contracts around only two percent of all arms exports over the life of the project (at can lead to procurement decisions that provide the UK military with current levels). Therefore, given the relative insignificance of the Hawk inappropriate equipment at excessive cost. Calculating the extent of this deal in the context of total UK defence procurement and exports, and problem is difficult, as the procurement process is relatively opaque: allowing for the fact that the sheer scale of distortion is unusual in this ostensibly for commercial and national security reasons. Since the York case, we consider a reasonable estimate that the overall annual implied Report was published (claiming that there are no known recent cases subsidy arising from the distortion of procurement intended to promote whereby a procurement decision has been influenced by export exports would be £200m. considerations), the Defence Industrial Policy of 2002 has stated that future export potential should play an explicit role in acquisition decisions, a point reiterated by ministers in evidence to the Defence Committee in May 2004.72 In addition, the publicity surrounding the recent Hawk deals Development of new systems (R&D): has thrown some light on the sums that can be at stake. While this up to £483m subsidy example may be unusual, it would appear to be indicative of the Government’s approach, and is not the only case that has required a There is considerable disagreement about whether it is legitimate to Ministerial Direction to over-rule the judgement of the Permanent apportion some of the Government support for military R&D as a subsidy 73 Secretary over efficiency. for arms exports. While some argue that R&D support would be forthcoming regardless of whether it might lead to foreign sales, others If the press reports are correct and MoD could have procured better 74 claim that if exports account for 40 percent of UK defence equipment aircraft at an overall cost of £1bn less than the Hawks, and if the decision production, then 40 percent of R&D spending should likewise be allocated to purchase these aircraft for the RAF has indeed been determined by a to exports.
The Government is heavily and directly involved in military R&D, spending 72 Lord Bach, Minister for Defence Procurement, in evidence to the House of Commons over £2bn a year, of which around £1.5bn is specifically for development.76 Defence Committee, 25 May 2004, published on 29 June 2004, HC 572-iv. Can be found at: Although the research enables MoD to maintain the expertise necessary http://www.publications.parliament.uk/pa/cm200304/cmselect/cmdfence/572/572we01.htm to be an ‘intelligent customer’, much of the development is conducted in 73 Private communication with officials. 74 Mary Fagan, `How the Hawk fought off an Italian predator`, Daily Telegraph, 19 July 2004, can be found at: http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2003/08/03/cchawk03.xml 19; 75 David Gow, `5,000 jobs safe as India buys Hawks`, The Guardian, 26 July 2004, can be MoD spends roughly £8bn per annum on UK defence equipment, according to the latest found at: http://www.guardian.co.uk/print/0,3858,4746652-111087,00.html 26 July 2004; figure in Defence Statistics 2003, table 1.8. We do not include fuel, clothes, administration Clayton Hirst, `MoD’s £6bn sweetener for BAE`, The Independent, 20 July 2004, can be and other costs not directly associated with equipment purchase and maintenance. found at: http://news.independent.co.uk/business/news/story.jsp?story=272761; David Assuming an average annual cost of £8bn (at 2001 prices) over the 25 years, we have a total Hencke, `MoD chief refused to sign £800m Hawk order`, The Guardian, 5 July 2004, can be spend of £200bn. found at: http://www.guardian.co.uk/print/0,3858,4815689-110595,00.html. 76 UK Defence Statistics 2003, op cit, table 1.7.
29 30 The Subsidies Escaping the Subsidy Trap direct collaboration with businesses in order to develop weapons systems By its very nature it is difficult to determine who benefits most directly from for the profit of those companies. The Government’s contribution to R&D. In the civil commercial sector the price of a product generally reflects military R&D is an indirect and inefficient mechanism to achieve a cheaper the investment (including R&D) required to develop, manufacture and price for MoD. market it. Prices in the military sector more strongly reflect a number of other factors including the subsidies and political support given to the MoD support for R&D comes in a number of guises, including Defence industry, personal connections, lobbying and the like. Technology Centres,77 the Defence Diversification Agency,78 the Defence Science and Technology Laboratory (DSTL, retained as an MoD agency) The Government recognises that its spending on R&D assists defence and QinetiQ.79 Additional government support, not accounted for here but exports, and it does charge a ‘Commercial Exploitation Levy’ on these to which is significant, comes through the Department of Trade and claw back some of this support. However, the income from the levy has Industry’s (DTI’s) Technology Partnership in Avionics,80 the Aeronautics been reducing significantly, to the point where the amount collected now Research Programme,81 Regional Selective Assistance under the only reaches around £12.3m a year, a tiny 0.5 percent of the government’s Industrial Development Act,82 Research Councils and EU research military R&D spend.83 programmes (such as the EU Framework Programme). There is also the R&D tax credit, which has been introduced this year and is designed to We can use a simple formula to estimate the top boundary of R&D subsidy reward companies for their research spending and to give them incentives for exports. Around 40 percent of the weapon systems constructed in the 84 to increase their development spending. UK are exported. If we were to assume that the government development spending is shared equally between exports and domestic procurement, 40 percent of the £1.5bn government spend on development
is £600m. Subtracting the Exploitation Levy, we are left with £588m. 77 DTCs are collaborative arrangements between MoD, industry and academia, which focus on defence science and technology to “generate and enhance the technology vital to the delivery of future UK Defence capabilities.” Each DTC will run for between 3-6 years and will be financed on a 50:50 basis by MoD and the participating commercial and academic Export contribution to fixed costs organisations. MoD has committed up to £5m each year for each DTC. 78 DESO estimates that the savings that accrue to the fixed costs of MoD The DDA is intended to “promote cross-fertilisation of technology between the defence 85 sector and industry.” procurement as a result of exports is some £300m. If we strip from this 79 In 2001 the MoD’s Defence Evaluation and Research Agency was split up into the Defence figure the £40m included within it for sales of surplus equipment (already Science and Technology Laboratory (DSTL, retained as an MoD agency) and QinetiQ, which included in DESO’s net budget) and the £50m included for the was prepared for privatisation the following year. DSTL research within MoD informs its Commercial Exploitation Levy (the average level of income received in the evaluation capability on a range of specialist sensitive military technologies. QinetiQ provides research and evaluation into new military and civil technologies. In February 2003, the 1990s), it reduces to £210m. We believe that this still fails to take into company was acquired by the Carlyle Group. But the MOD continues to hold significant account the range of factors that were discussed in section 1 (pages 15- economic interest with a stake of 62.5 percent of the business. 16), for example, the fact that exports are frequently sold near the 80 DTI provides significant support to the aviation industry, a sector heavily subsidised by marginal cost of production. We have, therefore, halved MoD’s estimate of successive governments because they have perceived it to be a flagship manufacturing the contribution to overheads, to £105m. This reduces the top-level industry. It is unclear why a successful industry would need such heavy subsidies. subsidy estimate from R&D to £483m. 81 DTI provides research grants for work on aerospace, frequently with dual-use (civil and military) development applications. Along with MoD it supports the National Defence And Aerospace Systems Panel, a corporate lobbying organisation that seeks to ensure government support for further research into civil and military aerospace, as well as running a 83 number (currently twelve) of Defence Aerospace and Research Parnerships, and producing Figure based on the last three years, given in a parliamentary written answer by Adam the National Defence Industry Technology Strategy, which steers so much of MoD’s R&D Ingram, MP, Minister of State, MoD, Official Report, House of Commons, 10 Jun 2004, col strategy. 589W. 84 82 The latest report on the Industrial Development Act can be found at Defence Statistics 2003, op cit. Exports amount to £4.1 bn. MoD spend on UK equipment http://www.dti.gov.uk/support/hc852_270803.pdf. In 2002/3 the RSA accounted for £294.6m purchases equals £6.4 bn (extracted from table 1.8). of government support. 85 http://www.deso.mod.uk/policy.htm
31 32 The Subsidies Escaping the Subsidy Trap
Unquantifiable elements Embassy staff (not including defence attachés) In countries that are significant purchasers of UK arms, or where a The following two categories have not been possible to quantify. Their potential deal is in negotiation, other embassy staff will use their general inclusion here highlights the fact that the value of the total annual subsidy relationships and political knowledge to help smooth the way for defence to UK arms exports (above) should be regarded as conservative, and that deals. Diplomatic staff in embassies in India, Saudi Arabia, Indonesia and the true figure is likely to be higher still. South Africa have been involved in military negotiations. However, costing such involvement has proved impossible. Official staff visits
Whether directly or indirectly, cabinet ministers and royalty are frequently involved in large defence contracts when they visit abroad. For example, in 2002, according to information released to Parliament, “Foreign and Commonwealth Office Ministers carried out [arms sales] promotion activities in Chile, Czech Republic, India, Singapore, Slovakia and Tanzania”.86 The Foreign Secretary, Jack Straw, claims that, “it is an entirely legitimate part of British ministers’ role overseas to support British industry, including British defence industries, and I am totally unapologetic about my very active support for all British industries, including the British defence industry”.87
Substantial numbers of support staff and advisers are usually involved in such visits, and their motivation and timing usually rests upon negotiations in progress on particular deals. While these visits represent a significant overall cost, in many cases it is very difficult to disaggregate the arms promotion component so as to calculate the specific arms promotion cost. In any case, the actual figure one may use to represent this pales into insignificance compared to the political, diplomatic and foreign policy costs and benefits of such visits.
86 Rt Hon Jack Straw, MP, Secretary of State for Foreign and Commonwealth Affairs, in response to a written parliamentary question from Rt Hon Menzies Campbell, MP, (Liberal Democrat Spokesman on Foreign Affairs), Official Report, House of Commons, 15 May 2003, col 401W. 87 Rt Hon Jack Straw, MP, Secretary of State for Foreign and Commonwealth Affairs, minutes of evidence to the Quadripartite Committee, 27 February 2003, appear in Strategic Export Controls Annual Report for 2001, Licensing Policy and Parliamentary Scrutiny, Second Joint Report of the Quadripartite Committee, op cit. Evidence can be found at: http://www.parliament.the-stationery- office.co.uk/pa/cm200203/cmselect/cmdfence/474##022701.htm. See also Jean Eaglesham and Edward Luce, `Anger as Blair uses Kashmir talks to sell Hawk jets`, Financial Times, 22 October 2002, p 6.
33 34 Conclusion & Recommendations Escaping the Subsidy Trap
5. Conclusion and policy Policy recommendations recommendations Marketing and Government Promotion
1 MoD should end public funding for the DESO and defence trade fairs.
2 MoD should end defence attachés’ involvement in arms export Conclusion promotion and reduce the numbers of attachés accordingly.
Arms exports do not benefit the UK economy or jobs. Subsidies to arms 3 Government Ministers should cease their involvement in military export exports distort the economy and divert resources, such as skilled labour promotion, and instead see their international diplomacy role as and R&D investment, away from alternative economic activity. Although focused on conflict prevention and the promotion of international exports protect a relatively small number of particular jobs, there are at security. least as many lost elsewhere in the economy. The evidence suggests that only in a handful of local economies that are particularly dependent on defence contracts would there be a significant impact from reduced arms ECGD exports. Government intervention would be better targeted at ameliorating this local dependency rather than artificially prolonging it. 4 The Secretary of State for Trade and Industry and the Chancellor of the Exchequer should review the position of ECGD. ECGD exposures Defence exports today more frequently involve the transfer of technologies should be valued at their market values to facilitate the proper abroad and the production of equipment in the purchasing country itself – management of their risk portfolio.88 Implicit subsidies should be either as is the case with the Hawk jet deal to India, which is another factor eliminated or at least recognised in the national accounts and justified minimising any employment or economic gain from the transfer. The in terms of their value for money against properly evaluated stated Government has recognised that the defence industry is now global in political and social objectives. They should then attempt to negotiate scope and that weapons platforms contain components sourced from similar moves multilaterally within WTO and OECD for all other export around the world. Given this development, the Government should credit agencies. abandon the historical and costly commitment to procuring weapons systems from UK sources solely for the purpose of ensuring ‘security of supply’ in all but the half dozen sensitive technologies that it has already Domestic Procurement identified. 5 MoD should reduce its spending on military R&D. Private companies We estimate that the subsidies provided to UK companies involved in should take greater responsibility for developing the products upon defence exports are worth at least £453m, and possibly up to £936m; in which their profits are based, and MoD procurement decisions should other words, between £7,000 and £14,400 for each job supported by exports. In actual fact, on the assumption that if subsidies were finished tomorrow there would still remain some defence exports from the UK, the 88 Whilst the inclusion of a cost of capital in the calculation of ECGD costs is to be welcomed, cost for each job supported by the subsidies would be considerably more we do not consider it is likely to result in the elimination of subsidy, for reasons we explained than this. At a time when public spending is under pressure the onus is on in written evidence submitted by BASIC to the House of Commons Trade and Industry Select Committee, available on their website at: the Government to withdraw the subsidies and encourage other countries http://www.parliament.uk/parliamentary_committees/trade_and_industry.cfm. Oral evidence to do the same. is on the Committee’s website http://www.publications.parliament.uk/pa/cm200304/cmselect/cmtrdind/uc506- iii/uc50602.htm.
35 36 Conclusion & Recommendations Escaping the Subsidy Trap
focus exclusively on life-cycle efficiency in delivering operational Appendix: Background to ECGD objectives.
6 MoD should separate defence procurement from export decisions in Claims that the government is in a better position to offer cheaper premium order to ensure that procurement decisions are taken solely on the rates than the markets are not credible; if it were true then it would be basis of defence needs and value for money. rational for the government to generate a profit by trading in international debt.89 Neither is the Government able to operate efficiently in this market, because of the narrow base of the exposures that it holds.90 Were the ECGD Employment to mark its portfolio to the market value (as required by International Accounting Standards,91 and what we attempt in our subsidy calculation 7 Government ministers should end their reference to jobs when below) this would then offer ECGD the opportunity to manage their credit justifying their support for arms exports, and instead focus their exposures in the same way they currently manage their FREF exposures.92 industrial assistance on the handful of local economies that are dependent on defence contracts. Government intervention would be We estimate from the ECGD annual report that approximately £5,000m of better targeted at ameliorating local economic dependencies rather debts relating to military contracts are outstanding at any one time.93 We than artificially prolonging them. further estimate that the sovereign governments who owe this money would, on average, pay 350 basis points (3.5 percent) over the UK government bond rate to borrow.94 We add a further 100 basis points (one percent) as an estimate of the additional contract and legal risk relating to such contracts, as
89 The NERA 2000 Report for ECGD (National Economic Research Associates, The Economic Rationale for the Public Provision of Export Credit Insurance by ECGD, 2000) cites on page 2 the major reasons for Government intervention as being risk bearing ability, privileged information and reputation. It is highly unlikely that the UK Government has a greater risk- bearing ability than the world financial markets, nor that it should choose to bear risks capable of being born by those markets and thereby lose the allocative efficiency advantages of competitive markets (NERA para 3.1.) And greater risk-bearing capacity would support all insurance being provided by the state. NERA recognise this logic in para 4.5.1. The subsequent conclusions of NERA that the lumpy long term nature of political risk explain the lack of a private sector market in political risk has not, with the emergence of the sovereign credit derivatives market, stood the test of time. It is equally unlikely that the UK Government has both access to and the ability to process privileged information on the repayment ability of foreign sovereigns, or that this ability would not be negated by political considerations in the decision to lend. 90 See, for instance, the 1999 KPMG Report for ECGD, Risk Management Review for HM Treasury and ECGD, 1999, para 1.3.4, 1.3.12. and elsewhere. 91 See International Accounting Standard 39, or the American equivalent, Financial Accounting Standard 133. 92 By hedging some exposures using derivative products. 93 The 2004 ECGD Annual Report shows that out of total support of £2,991m granted in 2003/4, 39 percent was defence-related. The total amount at risk at 31 March 2004 was £18,590m, of which £5,020m (27 percent), was defence-related. 94 Emerging market risk premia are highly dependent on the appetite for risk in the market, and fluctuate considerably. However, given the long-term nature of ECGD business, and the profile of their portfolio, this estimate is probably too low.
37 38 ECGD Background Escaping the Subsidy Trap
95 NERA and ECGD propose an alternative Value at Risk method for compared to pure sovereign debt. The annual value of the ECGD measuring the value of any subsidy. Given the use of the market to measure underwriting of these debts is therefore (3.5 percent + 1 percent) x £5bn = the subsidy for FREF, and the ready availability of an increasingly liquid £225m. ECGD charges, on average, a premium of £38m for this business, credit derivatives market, and a very deep sovereign debt market, this is so the net subsidy is £225m - £38m = £187m. To this we add £35m for inconsistent and untenable.98 FREF subsidies to reach a total figure of £222m for ECGD’s support to military exports.96 Our estimate is probably an underestimate of the true value of ECGD contracts to UK exporters. There is a significant delay between the date ECGD offers cover and the date the exporter confirms the contract. This represents a valuable option to the UK exporter, the value of which would need to be estimated on a case-by-case basis and which we have not been able to estimate.
The benefit from the subsidy is probably shared between the banks, the UK exporter and the overseas client. Corporate Finance Theory states that an organisation using cheap finance to fund a risky project will see an increase in its cost of capital. By analogy, the use of the Government balance sheet to support risk on the ECGD balance sheet will result in a small deterioration in the Government’s capital market debt rating, and hence a small increase in its cost of borrowing.97
95 We have no information on which to base this estimate, other than the complexity of the products and deals supported. 96 Prior to laying-off risk in the markets, the FREF subsidy was considerable. The 2003 NERA Report for ECGD, Estimating the Economic Costs and Benefits of ECGD, January 2003, p. vi, quote £300m in 1992 as the highest loss. The FREF scheme directly cost the UK taxpayer over £15bn (at 1999 prices) in its first 25 years. The cash loss appears in the ECGD accounts as the difference between income and expenditure on the FREF scheme. As the military and civil sectors are not disaggregated, for our purposes we estimate that the proportion attributable to military exports as being the same as that reported for ECGD business as a whole.
Figures in £,000 2001/2 2002/3 2003/4 3-year av Total FREF subsidy £141,212 £105,511 £21,597 £89,440 Percentage ECGD military 31 50 39 Estimated military FREF £43,776 £52,756 £8,423 £34,985 2002/3 2003/4 2003/4 Source in Annual Report Note 10, Note 12, Note 12, p.92, p.100, p.100,
97 Measuring this effect is not directly feasible due to the small size of the ECGD portfolio as compared to total government borrowing. However, the principle of rationing borrowing capacity 98 Much of the criticism of Value at Risk and the more reliable alternatives used here can be available to local authorities and other agencies is well established. Mechanisms to circumvent found in written evidence submitted by BASIC to the House of Commons Trade and Industry such rationing through derivative instruments were made ultra vires following the Hammersmith Select Committee, op cit. This contains extensive references to recent finance theory literature and Fulham debacle. Borrowing capacity allocated to ECGD is at the expense of borrowing and market journals. Oral evidence is on the Committee’s website capacity elsewhere in the state sector. http://www.publications.parliament.uk/pa/cm200304/cmselect/cmtrdind/uc506-iii/uc50602.htm
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